Car Loan Collector as Hedge Fund Manager: SEC Takes Action Against Adviser
You can hang a sign around your neck saying that youíre a hedge fund manager Ė but that doesnít make you one.
That would seem to be the core of the SECís case against two owners of an advisory firm who allegedly misled investors into sinking approximately $12 million into a hedge fund managed by someone who had "spent the majority of his career collecting on past-due car loans," the agency said. The two advisory firm owners are facing administrative and cease-and-desist proceedings, while the nominal hedge fund manager has already settled. The SEC on December 10 brought charges against Reliance Financial Advisers and its two owners, Timothy Dembski and Walter Grenda Jr., for steering their clients to invest in a hedge fund managed by Scott Stephan, "whose experience in the securities industry was greatly exaggerated in offering materials they disseminated."
"Investment advisers owe their clients a duty of complete candor when it comes to discussing investment options," said SEC New York Regional Office director Andrew Calamari. "In this case, Dembski and Grenda allegedly violated this duty by peddling a hedge fund investment that was more risky than depicted and misleading their clients about the portfolio managerís experience."
Who are you?
On February 11, 2011, according to the SEC, the fundís PPM contained a biographical paragraph on Stephan, which said he:
Was the co-founder and chief investment officer of the general partner to the fund;
Had exclusive responsibility to make the fundís investment decisions;
Worked in the financial services industry for more than 14 years;
Co-managed a portfolio of more than $500 million for another firm; and
Formerly held the position of vice president of investments for a New York-based investment company in which he was responsible for portfolio management and analysis.
"The PPMís description of Stephanís professional experiences prior to joining Reliance Group as well as his being Ďresponsible for portfolio management and analysisí Ö were highly misleading," the SEC charged, since he had no experience working in the securities industry before joining Reliance Group in 2007, and even after joining Reliance Group, he had "little-to-no experience selecting or making investments."
"At no point," according to the agency, "did Stephan provide Reliance Groupís clients with investment advice, trade any securities, or make any investment decisions. At most, Stephan Ė from time to time Ė discussed investment ideas with Reliance Groupís college interns and assisted Grenda with various research tasks."
"Dembski and Grenda allegedly knew that Stephan had virtually no hedge fund investing experience at all, and spent the majority of his career collecting on past-due car loans," the agency said. In fact, according to the SEC, "Stephanís only trading experience was investing approximately $1,000 that his father loaned to him in or around 2006 or 2007, which Stephan lost." None of this, however, stopped the advisory firm owners from recommending to clients Ė most of whom were retired or nearing retirement, and living on fixed incomes Ė from investing in the "highly speculative" fund Stephan
managed, according to the SEC.
The dollars allegedly lost were not insignificant. If what the SEC charges is true, Dembskiís clients invested approximately $4 million in the fund, while Grendaís clients invested approximately $8 million. The fund began trading in April 2011, but it didnít take long for the bloom to be off the rose. Grenda withdrew his clients in October 2012, after having lost approximately 4 percent of their collective investment. Dembskiís clients stayed invested a couple of months longer, only to see the fund lose about 80 percent of its value after Stephan began manually investing and trading in stock options, according to the agency. "Dembskiís clients, therefore, lost the vast majority of their [fund] investments," the SEC said.
While the advisers had, if what the agency alleged is true, a relationship with the fund manager that would have given them direct knowledge that some of the statements made regarding the fund were false, the larger lesson for most advisers is to perform thorough due diligence on a fund, including the professional background of the fund manager, said
Sidley Austin partner Mark Borrelli.
Violations and one settlement
The agency charged Dembski, Grenda and Reliance Financial Advisers with willfully violating Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act, as well as its Rule 10b-5, all of which outlaw fraud. In addition, all three were charged with willfully violating Sections 206(1) and (2) of the Advisers Act, which prohibit fraud. Dembski and Grenda were also charged with willfully aiding and abetting their firm in violating many of the same statutes, as well as Section 206(4) of the Advisers Act and its Rule 206(4)-8, for making misleading or untrue statements.
"My client believes he didnít do anything wrong. I do not believe he did anything wrong. When both the client and his attorney believe the client didnít do anything wrong, they fight, and that is what we are doing," said the attorney representing Dembski, adding that Dembski did not take any money to enrich himself. "Investments fail all the time." The attorney representing Grenda could not be reached for comment.
Stephan, however, chose to settle after also being charged with many of the same violations. He was barred from the securities industry, but was not ordered to provide disgorgement or a civil money penalty. Those remedies yet may occur at the end of the proceedings against the advisory firm and its owners. "Weíve been working with the Commission since day one, and weíre going to continue working with the Commission," said the attorney representing Stephan.
The fund and the algorithm
The fund that was later used to draw in investors was suggested by Stephan to Dembski in the summer of 2010, according to the SEC. It was supposed to employ an automated trading strategy of Stephanís own design, called "the Algorithm."
Unfortunately, Stephan and Dembski did not perform any real-time testing of the Algorithm, such as investing funds using its formula to see how they performed under actual market conditions. They may have back-tested the system, however, meaning looking at certain securities trading in the past to see how the Algorithm would have performed had it actually placed trades in those securities over those periods, the agency said.
It was not only Stephan who lacked hedge fund experience, according to the SEC. Dembski lacked "experience establishing or running a hedge fund or in algorithmic or other automated trading strategies," the SEC said.
And so the fund was created. The $12 million was then raised from Dembskiís and Grendaís clients from February 2011 to September 2012, according to the administrative order. Stephan, according to the SEC, helped recommend and sell the investments.
The SEC "seems to be requiring advisers to perform real-time algorithmic testing, implying that back-testing is not an acceptable substitute," said
Nixon Peabody partner Bradley Mirkin, who noted that the agency, in its 2014 exam priorities, referred to hypothetical and back-tested performance as an example of how it reviews marketing/performance as a core risk. "In the express language of its administrative order, the Commission criticized the adviserís failure to perform real-time testing prior to [the fund] being offered to prospective investors, such as by investing funds using its formula to see how it performed under actual market conditions. With todayís Division of Enforcement regime, real-time testing is an adviserís safest course."
"I donít think the SEC is saying that the adviser is required to perform real-time algorithmic testing of a model," said
ACA Compliance Group senior principal consultant Vicki Hulick, "but if the adviser is going to make claims that the fund will trade fully automated according to an algorithm and then make statements about how the model is going to perform, those statements must have some realistic basis. Back-testing alone may not be sufficient if the thesis of the model has not previously been tested."
"Back-testing alone has long been viewed as a risk because it is not all that difficult to come up with a model that worked in a previous set of historical circumstances, but with no way to know how it will work in the current environment," she said. "The SEC has long held that it is much more realistic to incubate an account or fund with proprietary money and test the modelís performance real-time to make sure it is working as expected so it can be sold as performing a certain way once the adviser has some real-world results."
Another issue, said Mirkin, is that the fund in this case was a proprietary fund presenting alleged conflicts of interest, which he said continue to be a special concern for the SEC. "Advisers should ensure that their policies and procedures on conflicts, proprietary funds and disclosure are up to date, reflecting their current product offerings and customer base." In addition, the fund managers allegedly changed trading strategies without disclosing that to investors, which he said is a red flag for the agency.
The SECís view "would be that people might invest in the fund in reliance on the use of an algorithm," said Borrelli, so switching to manual trades would be contrary to that expectation.